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The volume of default protection taken out on core-European sovereigns has fallen by almost a third since the summer, with analysts attributing the decline to a ban on taking naked CDS positions and ECB action to stabilise the region's bond markets.

Source: JP Morgan

As the attached chart from JP Morgan shows, outstanding CDS volumes are down 30% from last August, having fallen from $80bn to $57bn. The bank's analysts said the drop was driven by 33% declines in the amount of CDS written on French and German government bonds.

The European Securities and Markets Authority last year said it was banning the buying of CDS positions that do not act as a hedge. So-called “fast money” investors, typically hedge funds, use the instrument to express a view on a market rather than to hedge a specific position.

The ban came into force in November.

One credit analyst, not at JP Morgan, said: “The ban on naked CDS was always going to lead to a decline in volumes as the fast money dropped out of the market.”

Investors are still permitted to use the product as an insurance tool against the risk of default of government bonds that they hold, and to offset their potential losses from a decline in the value of sovereign bonds when other assets they hold are correlated to those sovereign bonds.

JP Morgan's analysts acknowledge this link but they do not regard it as a sufficient explanation for the sustained decline in volumes. They wrote: “One possible explanation for the significant fall in core CDS outstanding is the effect of Esma’s short-selling ban that came into effect in November. They banned cross-border hedging [CDS written on sovereigns to which investors are not exposed] which sparked a flurry of trading activity and led to significant unwinding of core CDS shorts.

“However, whilst it may explain unwinding behaviour before November, it does not explain the continuation of the trend afterwards.”

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They added that the Esma ban also fails to explain a decline in volumes in non-EU sovereign names, which on aggregate have fallen by around 15% over the last five months. These include Australia, for which volumes are down 40%; Japan, where they are down 15%; China, down 13%; and Brazil, down 7%.

Instead, they attribute the decline to a general improvement in sentiment following the European Central Bank’s pledge to support European government bond markets through direct purchases, or outright monetary transactions; and the agreement of fresh help for Greece.

“In our view, this evidence is more consistent with the unwinding of systemic hedges globally due to the perception of a significant reduction [in] tail risks post OMT and Greece’s aid agreements,” they wrote.